Signs of Recovery In Real Estate Give a Lift to Funds

By CONRAD DE AENLLE

Published: July 8, 2012

CORRECTION APPENDED

THERE was much for investors to worry about in the second quarter, but at least real estate was far down the list. Several reports hinted at a recovery in this long-suffering category, and that helped real estate investment trusts -- portfolios of various types of property, and traded on stock exchanges -- to outperform, along with funds that focus on them.

The latest report of the National Association of Realtors showed a 9.6 percent increase in sales of previously owned single-family homes in the 12 months through May and a 7.9 percent rise in prices. New-home sales rose 19.8 percent over the same period, according to Census Bureau data, and prices rose 5.6 percent.

Commercial property has been on an upswing, too. The most recent reading of an industry benchmark, the CoStar Commercial Repeat Sale Value-Weighted U.S. Composite Index, was 6.5 percent higher in April than it was a year earlier.

The improvement is hardly conclusive evidence that the multiyear decline in real estate prices is over, but it was enough to produce a 2.8 percent gain in the Vanguard REIT Index exchange-traded fund, by far the largest portfolio of its kind, in the three months through June, while the average real estate mutual fund in Morningstar's database was up 3.5 percent. The Standard & Poor's 500-stock index was down 3.3 percent during the period.

Many advisers recommend real estate investment trusts, or REITs, as well as funds that hold them. They provide income when it's hard to come by, these advisers say, as well as the prospect of growth from a market on the mend. But some worry that with profits still meager for developers and other property owners, valuations are excessive.

''You've got a lot of people who need income, REITs are in good financial shape, and they have a lot of opportunities to pick up buildings on the cheap,'' said Allan Flader, a financial adviser at RBC Wealth Management in Phoenix. ''On the other hand they are trading at rich prices. They're not by any stretch inexpensive by historical standards.''

In real estate, idiosyncratic accounting practices limit the usefulness of conventional valuation measures like price-to-earnings ratios. The preferred measure, the ratio of price to funds from operations, was recently about 18.5 for the average REIT, Mr. Flader said, versus a long-run average of 13. REITs have also been trading at about a 12 percent premium to net value of assets, well above the 3 percent average, he said.

Investors seem willing to pay up for assets that yield 3.3 percent, as an average REIT does, when 10-year Treasuries yield much less and require locking up capital for that long, and bank deposits and money-market accounts pay next to nothing. Being none of the above, neither bonds nor stocks, adds to REITs' appeal.

''REITs are getting so much play in the marketplace because they're a good bond alternative,'' said Jeffrey Leventhal, a partner in Bethesda, Md., for the financial advisory firm HighTower. ''More important, they're a diversifier in a portfolio because they move with bonds instead of stocks.''

Mr. Flader also appreciates that aspect of REITs -- and advocates a permanent presence for them in a stock portfolio. Five percent would be an average position, he said, but his valuation concerns and an expectation of a ''choppy'' rebound in real estate lead him to recommend a 4 percent holding now.

Mr. Leventhal, who sees himself as ''very favorable on commercial real estate,'' suggests having 5 percent in REITs, double his usual allocation. He prefers actively managed mutual funds, partly since the REIT world is so diverse.

Each trust tends to focus on one type of property, like apartments or retail, industrial or commercial buildings, including some with high profiles, literally and metaphorically, like One Penn Plaza, in Midtown Manhattan, owned by Vornado Realty Trust. Some REITs are quite specific, owning only shopping malls, say, or storage facilities.

This segmentation, Mr. Leventhal contends, gives knowledgeable managers an especially good chance to outperform. He likes funds including Principal Real Estate Securities, CGM Realty and Fidelity Real Estate Income. He also recommends the Vanguard E.T.F., although it is passively managed.

But for many investors, in his view, the Vanguard E.T.F. provides the best route into the sector. ''It gives you the broadest possible exposure to the domestic U.S. real estate market,'' Mr. Wherry said, adding that Vanguard funds also have relatively low costs.

INVESTMENT advisers caution that the narrow focus of many REITs can make them poor choices for small investors who build their own portfolios. For those who want to give it a go, Morningstar has given favorable ratings to Alexandria Real Estate Equities, BioMed Realty Trust, Corporate Office Properties, DiamondRock Hospitality, Hospitality Properties and Ventas.

Real estate analysts at Citi Investment Research gave positive ratings to some of the same: Alexandria, DiamondRock and Ventas. They judged Colonial Properties, Home Properties and Post Properties worth buying in the apartment sector and Kite Realty Group, Regency Centers, Retail Properties of America and Weingarten Realty among retailing REITs.

Mr. Flader's valuation concerns do not extend to REITs that specialize in foreign property. They trade at discounts to their net asset values of about 5 percent and yield about half a percentage point more than American REITs. That makes them worthy portfolio additions, he said. He declined to name examples, citing company policy.

One way for domestic REITs to reach bargain valuations, of course, is for their prices to decline. Real estate bulls like Mr. Leventhal envision a second scenario. If he is right, the sector should continue to give investors one less thing to worry about.

''There's a significant ongoing recovery in both residential and commercial,'' he said. ''It's a good idea to allocate dollars to it.''

PHOTOS: Real estate investment trusts are a diverse group. Alexandria Campus Pointe, an office complex in San Diego, above, is owned by Alexandria Real Estate Equities, while the Empire State Building in Manhattan is part of the ESB Trust. (PHOTOGRAPHS BY ERIC STAUDENMAIER FOR ALEXANDRIA REAL ESTATE EQUITIES; FRED R. CONRAD/THE NEW YORK TIMES); Vornado Realty Trust is the owner of the One Penn Plaza office tower, near Madison Square Garden in Manhattan. (PHOTOGRAPH BY SUZANNE DECHILLO/THE NEW YORK TIMES)

Correction: July 15, 2012, Sunday

This article has been revised to reflect the following correction: An article in the Mutual Funds Report, Part 2 of this section last Sunday, about real estate investment trusts, misstated the rating that Citi Investment Research gave to one REIT, Community Office Properties. It was a sell rating, not a buy. The article also misidentified the owner of the Empire State Building. It is Empire State Building Associates L.L.C., not ESB Trust.